Is it time the capital markets helped out with terrorism risk transfer and reinsurance?

A cross party group of members of the U.S. Congress have introduced a piece of legislation aimed at achieving the renewal of the U.S. government’s terrorism insurance backstop until the end of 2019. The Terrorism Risk Insurance Act is slated to expire at the end of 2014 and there is now a sense of urgency to get the renewal and extension of TRIA in place by the end of this year as the majority of terror insurance contracts have one year terms.

The TRIA allows for the U.S. government to pick up the bill for the bulk of any terrorism insurance loss above $100m in size. With the backstop in place insurers and reinsurers are able to put up much larger lines of capacity for terrorism coverage, safe in the knowledge that the government will foot the bill if the worst occurred. This means insurers don’t need to buy as much private reinsurance coverage and enables them to cover properties that without the backstop would likely not have terrorism coverage at all.

A bill has been proposed, (H.R. 508), which would enable the extension of what is officially known as the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA). The lead sponsors of the bill are Rep. Michael Grimm, R-N.Y., and Carolyn Maloney, D-N.Y., who both have seats on the House Financial Services Committee.

According to an A.M. Best article published yesterday, the facility does not protect insurers as much as you might think. Once the backstop is triggered insurers are required to cover a deductible of 20% of its premiums for TRIA covered lines. Insurers are also required to cover 15% of claims up to the TRIA facilities cap of $100 billion and the remaining 85% would be paid back by the federal government over time.

The article describes an example of a loss the size of the September 11 attacks on New York and quotes figures from an Insurance Information Institute study. The study says that for TRIA to be triggered an event would need to be on the scale of 9-11. In that case insurers could be on the hook for as much as $37.4 billion ($27.5 billion in deductibles plus $10.9 billion in co-pays). After that we assume the government would pay back a percentage over time.

One of the issues with the renewal of TRIA is that there is a significant amount of push-back in Congress from representatives who do not want to over-extend government finances and would like to see the risk pushed elsewhere. Given the partisan debates over fiscal issues and government budgets it looks like TRIA renewal could face a tricky passage through the legislative branches.

So perhaps there are other ways to construct a privately funded and supported terrorism reinsurance facility which would enable insurers to provide terrorism cover and helpt to minimise or reduce the burden on government finances? The capital markets and alternative risk transfer instruments such as catastrophe bonds or collateralized reinsurance providers naturally come to mind as potential enablers for accessing new sources of capital with suitable risk appetites.

We wrote about this before when the TRIA was a hot topic in August 2010 and the ideas we proposed continue to be discussed within the reinsurance and ILS markets at events and industry meetings. Capital market risk transfer instruments like catastrophe bonds, ILWs or collateralized reinsurance would provide a way to structure terrorism related risks in a form which could be ceded to capital markets investors. This would enable institutional investors to take, or reduce, some of the burden from the U.S. government, and would also diversify the sources of capital within the overall terrorism risk backstop. Our conversations with market participants suggest a market for this risk may be feasible, the appetite to take on this risk does exist, but many caveats apply.

Uncertainty and a lack of risk modelling for terrorism is one issue which could hold back the development of a private, capital markets backed, terrorism reinsurance backstop. Given the human element within a terror attack it is difficult, to impossible, to really fully quantify the risks of attack. However models have improved in recent years and so also has the risk appetite and appreciation of basis risk among institutional and specialist reinsurance investors.

Structuring terrorism risk cat bonds would be a challenge and any structures devised would need to put investors at their ease that the risk was as clearly understood as is currently practicable. Indemnity triggers could of course be used to protect specific insurers, but would investors buy into the probabilities of attachment and exhaustion that the risk models derived?

An industry loss based terrorism cat bond is another potential solution. As is common in natural catastrophe bonds, a source could be selected as reporting agency which would reveal the insurance industry loss figure against which a cat bond could be triggered. Again, the derivation of attachment probabilities and expected losses may be the issue here as historical loss data is not as abundant as in natural perils.

Another alternative might be indices created based on various factors associated with terrorism risk, or even some kind of parametric cover designed purely for the peak terror exposures for key and important buildings. Would investors buy into that kind of structure without the robust historical event modelling that they are familiar with from other cat bonds or would they accept a modelled loss view of the risks?

The catastrophe bond and insurance-linked security market does contain terrorism risk, but only in terms of mortality risk associated with terror events, through transactions such as Swiss Re’s Vita Capital V Ltd., and previous Vita deals, which provide the reinsurer with a source of extreme mortality protection.

So the mortality increase side of terror attacks can be transferred to the capital markets already. If some method could be devised to sensibly structure cat bond or ILS type instruments to transfer the risks of property damages from terror attacks to the capital markets as well, we could get some way towards a privately supported terrorism reinsurance backstop.

Such a private, or capital markets, funded backstop would take the strain off the government backstop and some burden off taxpayers, while meeting the goal of enabling insurers and reinsurers to provide terrorism cover. Such a privately funded solution is a way off, but it is important that such ideas are discussed and considered.

Some would say the U.S. government and taxpayer cannot afford to be on the hook, should the worst happen, and that capital markets and institutional investors may have the risk appetite and be the only source of capital large enough to help support it, under the right deal terms and with attractive coupon payments.